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How Startup Valuation Works At The Seed Stage

How Startup Valuation Works At The Seed Stage

What are the questions to be asked at the seed stage to determine the valuation

Timing is vital because if founders and startups take too much time, they might face increased competition in the market

Factors such as traction, revenues and prototyping help determine valuation to a certain extent

It is a well-known fact that raising funds is an inevitable part of any startup’s journey, and for establishing a successful business, startups need to go through different rounds of raising funds, which are pre-seed, seed and series rounds. If we talk about the seed stage, the timing of raising funds and the actual amount that one wants to raise holds the key.

Timing is vital because if founders and startups take too much time, they might face increased competition in the market, and on the other hand, arriving too early may put the startup at the risk of not being relevant in the market. So, by the time a startup reaches the seed funding stage, its product needs to be ready to be launched in the market.

However, the main problem arises when a startup is not able to pool in funds from the founder’s savings or internal sources and have to resort to external avenues such as micro VCs, angel investors or groups and incubators. In order to approach any of the above-mentioned external sources, startups need to figure out the seed amount required. This is where seed funding valuation comes into the picture. So, before we proceed any further, let’s discuss this process in a detailed manner.

What Is Startup Valuation?

In simple terms, startup valuation is the process of quantifying the worth of a company, aka its valuation. During the seed funding round, an investor pours in funds in a startup in exchange for a part of the equity in the company. This is why valuation is important for entrepreneurs as it helps in determining the equity which they have to give to a seed investor in exchange of funds. It is also of great importance for an investor as they need to know how much company’s share they will receive in lieu of the funds invested during the seed stage. So, fundamentally, startup valuation can prove to be a real deal maker or breaker, which is why valuation does not involve any guesswork on the basis of valuation of other similar startups.

In addition, before proceeding with calculating the actual value of a company, founders need to have proper knowledge about how the entire process of startup valuation works. Quote an absurdly high figure to seed investors, even when there is no revenue generation, and the expectations will be quite high, and if a startup is unable to meet the high targets, it might have to raise funds at a lower valuation in the next round.

This may prove negative in the long run, and the startup or founder might have a tough time convincing other seed investors or companies for seed funding. Conversely, quote too low and the startup may end up giving a larger chunk of equity to investors, which will again prove negative.

Valuation Factors For Startups At Seed Stage

Now that we have seen how a right or wrong valuation can actually be a deal maker or breaker, this brings us to the next logical question, which is how to calculate startup valuation. But, before we get to know how it is done, let’s look at the factors which influence the valuation of a company:

  1.  Traction
    This is one of the major factors that impact the valuation for seed stage. Principally the quantitative proof of customer demand, traction shows that a startup is taking off. In simple terms, traction demonstrates development and growth, which is why it is the most important aspect that convinces investors to invest money in a company.
  2. Reputation
    Before proceeding ahead with the round of valuation, founders need to ensure a positive image in the market. One of the most important things that an investor looks at before investing is the founder’s image and his capability.
  3. Prototype
    Development of a prototype is a major factor that can influence the decision of an investor. So, before planning to pitch an investor, make sure the prototype is ready.
  4. Pre-valuation Revenues
    Undoubtedly, revenues are important for any company as they make it easier for investors to carry out the valuation. So, if a product has hit the market and is already generating revenue, it could sway the investor’s decision in the favour of that startup, and prove to be a real deal sealer.
  5. Distribution Channel
    In the initial stages of any startup, it is very likely that the product/service will be in preliminary stages too. Hence, founders need to be careful about the distribution channel that is being used, as it can have a direct impact on the valuation.
  6. The Industry
    If the startup belongs to a booming industry, it is highly likely that investors will pay a premium. This implies that it is important to choose the right sector as it will increase the worth of a business enterprise.

Coming to the next point, which is the manner in which the value of a startup can be calculated. First and foremost, carry out self-assessment, which includes making a list of assets. This step also comprises the identification of KPIs or key progress indicators like success rate, user growth rate and referral rate.

In addition, have a good team in place as it goes a long way in attracting investors.

The second step is the selection of a startup valuation model, like Berkus Method, Risk Factor Summation Method, Scorecard Method or Cayenne Consulting Calculator.

The third step is understanding the difference between pre and post-money valuations and making adjustments for reverse factoring.

Importance Of Startup Valuation

Now that we have discussed what exactly startup valuation is and which factors influence an investor’s decision, it is important to know why it is vital at every startup. Valuation matters to every startup because it helps in deciding the amount of equity an entrepreneur has to give to an investor in exchange for requisite funds. This implies that if a company has a higher valuation, it has to give a lesser amount of equity or shares to an investor in exchange for seed investment. Not only for entrepreneurs, but startup valuation is also vital from investors’ point of view because it helps them gauge the amount of return they will receive on their invested amount.

We have seen why valuation is important for both startups and investors and how it can be calculated. So, before proceeding with the seed fundraising round, the above-mentioned points need to be followed to analyse which valuation method is the most suitable for each specific startup. Apart from all the algorithms, models and valuation factors, founders need to be flexible, keep expectations realistic and utilise all the resources effectively.

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